Musings on World events from the perspective of a Social and an Economic Liberal.

Monday, October 26, 2009

Bank Bonuses: Why Osborne makes it worse

Even though the latest bank bonus payments have been greeted with predictable outrage in the usual quarters, in this case the "usual suspects" have a point. The concern about the financial industry for some time has been that the owners of bank capital have had their returns hijacked by bank staff. Certainly even before the crisis, the return on capital of banks over the past decade- mostly in single figures after bonuses- looked pretty anaemic. By contrast the payments to staff at banks have been substantially higher than investor returns. In the end, as we now know, the return on capital over the past two years has been so negative as to wipe out the balance sheets of several financial institutions. This has required the injection of billions from the taxpayers of the United States, United Kingdom and several other countries.

Several banks are now either owned by the state or rely on the state for their survival through a variety of measures- including the extremely expensive rescue of AIG. This, however, has not stopped the payment of this injected capital still going to staff rather than to rebuild bank balance sheets. When the bonus pool is larger than the value of state support, as it is in several instances, then effectively the shareholders -i.e. the state- are being robbed by the management and staff that they employ.

Neither, by the way, is the delayed payment of bonuses in shares a solution- it simply takes away a cash cost and replaces it with a dilution of the share capital- and the effect on shareholders can often be worse than if they paid out in cash. Thus George Osborne's demand that bonuses above £2000 should be paid in shares is not much of a solution.

By paying out bonuses on such a scale to employees who are only able to do business because of government capital, the management of these banks are flying in the face of the very capitalism that they purport to defend. If they choose to make such payouts as a private company, that is a matter for the shareholders- who are obviously happy to be ripped off. As the trustees of the state, it is extraordinary that government representatives did not reject the idea that the bonus pools should not be funded from profit, but from capital. It is creating the ultimate moral hazard in the financial system.

That is a significant cause of the original crisis: and has fed irresponsibility across the board. Osborne- as is becoming usual with his policy pronouncements- is taking aim at the wrong target. Instead of demanding that the total bonus pool be paid out of a fixed percentage of profits made, he has accepted that it should be paid out of capital- albeit in shares rather than cash. By setting the individual limit at £2000, he is only allowing the lowest clerks to get cash, but in any event it is more expensive to administer share payments rather than cash payments. Osborne's idea does nothing to address the fundamental problem that staff are generally being favoured at the expense of shareholders. Indeed by increasing costs and not reducing the overall pool to reflect profits, he ensures that the taxpayer gets an even worse deal.

As Mr. Osborne makes a speech in the City this morning, he may reflect that he is not particularly respected amongst the financial community. He is likely to continue to fail to assert his authority with this further badly thought out and even counter productive initiative.

The bonus pool should reflect the value added by staff. If it does not then shareholders are funding dangerous risk taking with no moral hazard to the decision makers they contract to conduct the business. When the bonus pool is beyond the level of returns offered to shareholders, there is clearly something wrong.